Myths About Construction Loan Management

Fund Control and Inspections work better together.

A four-course meal at a five-star restaurant could certainly be broken down into its component parts and eaten à la carte. The salad course would be very good on its own. However, something is lost when a carefully planned meal is not eaten as a whole. Construction Risk Mitigation is very similar; all the parts of CFSI’s Construction Risk Mitigation Process work together to give lenders the most protection with their construction projects.

All of the services CFSI offers work together to provide the best Construction Risk Mitigation service to our clients. Knowing that the contractor has the proper experience/licensing to complete a project leads to more confidence in the contractor’s budget/bid for a project. Knowing that the project’s budget is adequate for the planned construction and is detailed enough, which leads to more confidence in inspection reports and collection of support documentation during Fund Control.

Two aspects of Construction Risk Mitigation really need to work in concert in order to be fully effective: inspections and fund control. This is particularly true of rehab projects. There is no matrix for percentage of completion on rehab projects, as they are all totally unique in their scope, unlike ground-up projects. Thus the percentage of completion is heavily dependent on what is being requested. Determining a percentage of completion on a rehab project without knowing what is being requested is, at best, an educated guess. This can often lead to a lender disbursing more on a construction project than has actually been spent. This can also lead to misappropriation of loan funds. The most common occurrence is the borrower using funds from the lender’s loan on another project.

In order to avoid this issue, the Fund Control process requires the following:

Detail on exactly what is being requested against the budget. Not only does this information give an exact percentage on what should be complete, it can also uncover cost overruns. For example, a borrower requesting $10,000 from a $5,000 framing line indicates that there has been a change order.

Support documentation to support the request, specifically invoices. Not only does this information allow the lender to ensure that payees enjoying lien rights are paid (collection of unconditional lien waivers), but it also shows the actual costs incurred on the project. A supplier invoice will show that the materials were provided for the lender’s project, giving confidence that loan funds will be spent on the lender’s project. These invoices should also add up to the amount requested, thus giving further confidence that the percentage requested is backed up by costs.

These two items working together give a clear indication of what is being requested and what the inspector should verify is complete on site. If the request is for 65% of the project, backed up by invoices, the inspector can then verify work in place. If a borrower is insisting on receiving 85%, but can only support 65% through stated work completion and invoices, a lender should only disburse for what has been completed. Advancing funds in variance to the percentage of completion is a recipe for issues down the line.

Over the past several years, CFSI has noted that many lenders are relying solely on status inspections to determine what to fund on a construction project. This has lead to several issues. Most commonly, borrowers are upset that they receive less than what they expected. This is due to CFSI not knowing up front what the borrower is requesting. For example, the borrower is expecting 90%; our inspector goes to the site, and gives an overall percentage-of-completion percentage at 80%. The borrower complains back to the lender on the 10% shortage. If CFSI had the percentage requested, we could have commented on why the project is not 90% complete.

On the flip side is the opposite problem! When a project goes bad, for whatever reason, lenders tend to come back to CFSI and complain that our percentage of completion was too high. Often this happens on projects where the borrower exerted pressure to increase the percentage of completion on earlier draws. If CFSI had been performing Fund Control, invoices supporting the amount requested would have been collected and the lender would have confidence that the costs incurred matched the percentage of completion.

CFSI assumes that the lender is performing Fund Control on projects where CFSI is only doing Status Inspections. Based on this premise, CFSI is moving towards providing photos and comments on whether a project is progressing only for Status Inspections. The lender can then use the data collected for Fund Control to determine the percentage of completion. CFSI would provide line-by-line and overall percentages of completion on projects where we are handling the Fund Control process, thus eliminating the complaints on the percentages of completion.

Sometimes getting some food à la carte is the way to go. However, some foods just go better together. Like marinara sauce and pasta or ice cream and pie. Fund Control and Inspections work much the same way; both are better together.